THE ROLE OF MONEY – MONEY AND MONETARY POLICY IN THE TWENTY-FIRST CENTURY -FIRST CENTURY FOURTH THE ROLE OF MONEY – MONEY AND MONETARY POLICY IN THE TWENTY THE POLICY IN AND MONETARY OF MONEY – MONEY THE ROLE ECB CENTRAL BANKING CONFERENCE 9-10 NOVEMBER 2006 ISBN 978-928990207-6 EDITORS ANDREAS BEYER 9 789289 902076 EUROPEAN CENTRAL BANK EUROPEAN LUCREZIA REICHLIN THE ROLE OF MONEY – MONEY AND MONETARY POLICY IN THE TWENTY-FIRST CENTURY FOURTH ECB CENTRAL BANKING CONFERENCE 9-10 NOVEMBER 2006 EDITORS ANDREAS BEYER LUCREZIA REICHLIN © European Central Bank, 2008 Address Kaiserstrasse 29 60311 Frankfurt am Main Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main Germany Telephone +49 69 1344 0 Website http://www.ecb.int Fax +49 69 1344 6000 The views expressed in this volume do not necessarily reflect those of the European Central Bank and the Eurosystem. All rights reserved. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged. ISBN 978-92-899-0207-6 (print version) ISBN 978-92-899-0208-3 (online version) CONTENTS INTRODUCTION by Lucrezia Reichlin ................................................................................... 5 OPENING ADDRESS The role of money by Jürgen Stark ........................................................................................... 16 SESSION 1 HOW IMPORTANT IS THE ROLE OF MONEY IN THE MONETARY TRANSMISSION MECHANISM? Two reasons why money and credit may be useful in monetary policy by Lawrence J. Christiano, Roberto Motto and Massimo Rostagno .............. 28 Does a “two-pillar Phillips curve” justify a two-pillar monetary policy strategy? by Michael Woodford ................................................................................. 56 Comments Christian Noyer .......................................................................................... 83 Harald Uhlig ............................................................................................... 87 General discussion ..................................................................................... 97 SESSION 2 HOW USEFUL ARE MONETARY AND CREDIT AGGREGATES IN THE CONDUCT OF MONETARY POLICY? Money and monetary policy: the ECB experience 1999-2006 by Björn Fischer, Michele Lenza, Huw Pill and Lucrezia Reichlin .............. 102 Comments Philipp M. Hildebrand ................................................................................ 176 Jordi Galí ................................................................................................... 182 General discussion ..................................................................................... 190 KEYNOTE SPEECH The role of money in the conduct of monetary policy by Lucas Papademos ................................................................................... 194 3 SESSION 3 WHAT ARE THE BENEFITS OF RESPONDING TO MONETARY DEVELOPMENTS? Pillars of globalisation: a history of monetary policy targets, 1797-1997 by Marc Flandreau ...................................................................................... 208 Comments Michael D. Bordo ....................................................................................... 244 Christian de Boissieu .................................................................................. 252 General discussion ..................................................................................... 256 HONORARY ADDRESS The ECB’s monetary policy strategy: why did we choose a two pillar approach? by Otmar Issing .......................................................................................... 260 SESSION 4 PANEL: MONEY AND MONETARY POLICY – ACADEMIC VIEWS Panel discussion Ricardo J. Caballero ................................................................................... 272 Jean-Pierre Danthine ................................................................................... 284 Mark Gertler .............................................................................................. 290 Tobias Adrian and Hyun Song Shin ............................................................. 299 General Discussion ..................................................................................... 310 SESSION 5 PANEL: MONEY AND MONETARY POLICY – POLICY VIEWS Panel discussion Ben S. Bernanke ......................................................................................... 314 Kazumasa Iwata.......................................................................................... 321 Jean-Claude Trichet .................................................................................... 331 Zhou Xiaochuan ......................................................................................... 337 General discussion ..................................................................................... 342 CLOSING ADDRESS by Jean-Claude Trichet ............................................................................... 346 Programme................................................................................................... 350 4 INTRODUCTION BY LUCREZIA REICHLIN, ECB There is an apparent paradox in modern monetary policy theory. Although there is no doubt that monetarism gained an important intellectual victory after the great in ation of the 1970s and we can say that, citing a phrase used by Michael Woodford (Columbia University) at the conference whose proceedings are published in this volume, “we are all monetarists now”, both in policy practice and in the academic mainstream, money has lost its central role. Most central banks in the world are now giving a prominent role to the price stability objective and most of them have adopted in ation targeting as a strategy (see the 2007 BIS Annual Report for a review of strategies at different central banks). Moreover, the new Keynesian model, the basis of quantitative analysis in the modern theory and practice of monetary economics, does not assign money a special role for the control of in ation. This model, although it implies the basic monetarist principle of the neutrality of money, determines the equilibrium price level without any reference to the money supply. The fourth ECB central banking conference provided a oor for both academics and policy makers to explore this paradox. It is perhaps appropriate for the ECB to have chosen this subject for its fourth conference since, although it does not target monetary aggregates, the ECB is the only institution, amongst major central banks, to clearly attribute a special role to money under its “two pillar strategy”. The ECB has been much criticised, especially in academic quarters, for the monetary pillar aspect of its strategy, yet it is widely recognised that the ECB has been successful in maintaining price stability in the Euro area. Is practice ahead of theory, as the intervention of Otmar Issing (former ECB Board member) suggests? To nd an answer to this broad question, the conference looks at the problem from different perspectives: analytical, empirical and historical, each of them discussed in a different session. From the theoretical point of view, the question is whether the neglect of the special role of money in the basic neo-Keynesian model is due to its simplistic nature and, in particular, to the absence of credit frictions and the disregard of the role of nancial markets. From the empirical point of view, the question is what role the money pillar has actually played in the practical conduct of monetary policy in the Euro area. This is a difficult question to address given the short history of the institution, but it can, at least partly, be analysed on the basis of eight years of data. If the history of the ECB is short however, there are other historical experiences that one can look at to shed light on the debate about the conduct of monetary policy. In the third session, Marc Flandreau (Institut d’Études Politiques de Paris) looks at two hundred years of European history to shed some light on why, INTRODUCTION 5 over time institutions have adopted particular targets, while in the policy panel Chairman Bernanke (Federal Reserve), Deputy Governor Iwata (National Bank of Japan), Governor Zhou Xiaochuan (People’s Bank of China) and President Trichet (ECB) examine the experience of their respective institutions. Let me start from the analytical question of the role of money in the monetary transmission mechanism, the focus of the rst session. As mentioned, the macroeconomic model which represents the core consensus in modern macroeconomics and which is the basis of the models that are routinely calibrated or estimated at central banks to inform the policy process, does not give money a central role. In its most basic version it consists of three equations – an aggregate supply relation, an inter-temporal IS curve in which monetary policy affects aggregate expenditure via the expected short term real rate of return, and a third equation that closes the system by specifying monetary policy. Monetary policy is typically speci ed by means of a Taylor rule. In this model, in ation is determined by the in ation target of the central bank and by the gap between the natural rate of interest and the intercept adjustment in the Taylor rule. The model, although it has no explicit reference to the money supply, implies a determinate in ation rate and, given an initial price level, a determinate path for the price level. Although it implies that the equilibrium price level depends on monetary policy, and